When advising clients on the acquisition of a multi-unit franchise network, we are often posed the age-old question: “Should we own the assets in one entity or multiple entities?” At the risk of sounding too much like a lawyer, the answer to this question is, “It depends.” Each franchisee has a unique set of hot button issues, which generally inform our response to such an inquiry. For some operators, insulation from liability is paramount; for others, limiting transaction costs is a primary concern. While there is no one-size-fits-all answer, it’s important to review the benefits and detriments that come with both ownership structures.
Insulation from Liability
Prevailing trends and best practices dictate that each franchised restaurant be held in its own single purpose entity, so as to insulate each independent business from the liabilities of the others. By implementing this strategy, franchisees can generally contain exposure to claims levied by employees, creditors, and patrons to the entity in which any alleged liability arises, thereby ensuring the liability does not contaminate the other restaurants in his network. For example, if an employee of one of the restaurant entities brings a successful action for unpaid wages, he could only look to the assets of that restaurant entity to satisfy his damages; all the other restaurants would be shielded from liability because they were owned by separate entities.
Let us now examine the countervailing philosophy. What if a franchisee sought to realize some of the benefits of single entity ownership, and opted to an entire network with one LLC? From a risk management perspective, this decision would certainly expose the entire network to the cross-contamination of liability arising at one restaurant. Thus, under this scenario, if a patron slips and falls at one of the restaurants, that individual could look to the assets of all network locations to satisfy a judgment. However, notwithstanding this example, the operator could mitigate against such network-wide damages through the purchase of appropriate business insurance policies.
Credit and Financing
Let us now consider that a franchisee may need to obtain institutional debt as a means to finance an acquisition. By acquiring a network through multiple entities, a franchisee is certain to drive-up the transaction costs associated with his loan. At a minimum, most lending institutions will require certificates of good standing ordered and lien and judgment searches be conducted on each purchasing entity. Additionally, the franchisee will typically be required to pay his own legal fees, in addition to those incurred by the bank. Thus, the use of multiple entities will invariably result in the creation of more legal work and higher fees, since numerous documents will have to be drafted—authorizing each entity to enter the transaction, and borrow and guaranty the bank debt. Conversely, the use of a single entity to acquire the entire network could result in tens of thousands of dollars in cost reductions.
When it comes to landlord-tenant relations, there are pros and cons with each network entity structure. For instance, to the extent the franchisee uses a separate entity for each restaurant, such entity will typically sign as the tenant under its lease. Accordingly, if the location turns out to be poor performing, the franchisee can determine to close the restaurant, or threaten to do so in order to leverage negotiations with the landlord. Assuming there are no personal guarantees on the lease, the landlord would be left with the option of re-negotiating the lease terms or commencing an action against an insufficiently capitalized entity.
Unfortunately, the benefit illustrated above is more theoretical than practical, as most landlords will require that the principal(s) of a single purpose entity personally guaranty the tenant entity’s obligations under the lease. To that end, even if a franchisee owned the store in a single entity – if he decided to close the restaurant – he would likely face personal liability for unpaid rent.
That example allows us to segue into one of the more valuable benefits derived from owning the network in one entity – the increased potential for avoiding personal guarantees on leases. The fact is, when signing a lease with a tenant entity that owns the assets of multiple Dunkin’ Donuts restaurants, the tenant has more leverage in convincing the landlord that a personal guaranty is not necessary. From the landlord’s perspective, a tenant entity that owns multiple Dunkin’s may have sufficient assets and cash flow to satisfy a claim or judgment for unpaid rent, such that the backstop of a personal guaranty is not necessary.
Cross Defaults under the Franchise Agreements
One often overlooked issue when determining entity structure is the existence of the “cross-default” provision in the Dunkin’ Donuts and Baskin-Robbins franchise agreements. Section 14.06 of the franchise agreement provides that, “We terminate any other franchise agreement with you or any affiliated entity by reason of a default under sections 14.0.3, 14.0.4 or 14.0.5.”
According to this provision, a termination of one Dunkin’ franchise agreements can give rise to the termination of all of a franchisee’s other Dunkin’ franchise agreements. The courts in some states have held that the “cross-default” provision may be enforceable regardless of whether the franchisee’s Dunkin’ restaurants are owned in one entity or many. However, some courts have shown a hesitancy to enforce the “cross-default” provision when the restaurants are owned in multiple entities. You should contact your franchise attorney to learn how the courts in your jurisdiction(s) treat this issue.
In general, our firm most often counsels our multi-unit franchisee clients to implement the multi-entity structure, based on the flexibility and protections against financial and business liabilities such an entity offers. •
David S. Paris is a founding partners of the law firm Paris Ackerman & Schmierer LLP. Craig Feldman is of counsel, heading the firm’s commercial real estate department.